Ukraine’s Show of Force Impact on Markets & Inflation’s No Good Very Bad Day
September 16, 2022
Is Ukraine’s Show of Force Positive for Markets?
Recent developments in the Russia / Ukraine war have spread an air of optimism. It offers the idea that Putin might not have a choice but to look towards de-escalation in the region. This comes after Ukrainian troops took back the towns of Kupiansk and Izyum over the weekend, causing Russian troops to retreat from the area. This is a big win for Ukraine as these two towns were major logistical hubs for Russian troops in the Donbas region. This recent reclamation of land takes the total of retaken land to over 6,000 square kilometers since the beginning of September. But where does this leave European energy concerns?
The Ukrainian troop advance jeopardizes Russia’s goal to conquer Western Donetsk. This latest victory for Ukraine might encourage more support from the West and encourage troops to keep driving Russia out. However, the flip side of this success is that it significantly decreases the likelihood of a ceasefire in the near future. It might even cause Moscow to inflict more economic pain on the rest of Europe through its control of energy supplies. This will become almost certain if the EU follows through with its proposed embargo of Russian seaborne crude imports in December. Because of the increasing likelihood of energy supply disruptions, the EU has adjusted its natural gas storage capacity goals. As of September 13, EU’s gas storage is 84% full, and they are aiming for more by November.
The downside of filling reserves so aggressively is that gas prices have shot up 2-3 times vs. previous years. The combination of further energy disruption and decreased ceasefire likelihood makes it unlikely for gas prices to come down soon. While this is negative overall, it is actually a positive development for companies in the sustainable energy value chain. Most countries will double down on renewable energy as it is not just an environmental issue but a geopolitical and economic security issue. Removing the need for natural gas at a time of soaring prices and Moscow threats will be a high priority for years to come. Countries without easy access to natural gas or oil resources will have to invest in domestic renewable energy production, causing sustainable energy stocks to outperform.
Inflation’s No Good Very Bad Day
Tuesday’s inflation report disappointed on most fronts. While headline CPI was +0.1% in August vs. -0.1% expectations, the main story was core CPI at +0.6% vs. +0.3% in July. Investor focus was squarely on higher-than-expected shelter and medical care costs, as well as a reacceleration of new vehicle prices. Most alternative measures created to adjust for COVID also showed nothing positive: trimmed mean, median, sticky prices, services ex energy and core (ex food and fuel) definitions all rose more than expected, and all but one are at fresh peaks. As this was the last major inflation print before the Fed’s meeting, the market repriced to assume a 75 bps hike as given and a 50 bps November hike as likely.
Was there good news? Energy prices fell significantly, and food inflation slowed (with all five sub-indices of the FAO Food Price index declining). Both trends continue in September. These costs hit day-to-day wallets immediately and have real impact, whereas some economists describe the CPI’s Owner’s Equivalent Rent calculation for shelter as “a massively lagging fantasy that no one pays.” Perversely, raising rates to fight inflation also raises the 30yr mortgage rate (at 6.2, now double 12 months ago). This makes housing less affordable and will lead to a deceleration in shelter CPI in 6-12 months. Looking at real-time rent and housing price data, a slowdown is well and truly underway.
Most importantly, consumer inflation expectations are low. The New York Fed’s latest Consumer Survey showed 1yr household inflation expectations dropping from 6.2% to 5.7% and 3yr from 3.2% to 2.8%. These moves are material and highlight again that gas and food prices matter more for consumers than anything else. The low readings suggest the Fed has regained credibility with the public and won’t need to engineer a deep recession to tame inflationary pressures.
So what to make of market moves? We are in the Fed’s quiet period ahead of next week’s meeting, so markets will have limited official guidance in the coming days. It’s important to remember that Tuesday’s 4% S&P 500 drop – while painful – only erased the prior four days’ gains. The S&P 500 right now is at the same level as last Wednesday. The stage is set for strong employment and corporate profit data to battle inflation worries and Fed fears into year-end. Long-term investors should ignore short-term volatility and priorities areas likely to do well on a medium-term basis. Profitable high-quality US growth and defensive Intl income stocks stand out in our view.
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